During the last three decades, developing countries have made enormous strides in opening up protected domestic markets to international trade and foreign investment. Yet most countries have not simply opened up their markets. They have also instituted a range of policies to encourage exports, attract foreign direct investment (FDI), promote innovation, and favor some industries over others. This set of government interventions fall under the overall heading of “industrial policy” (IP). This KinD Note provides an overview of the arguments and evidence for and against these policies.[1]

Theoretical justifications for industrial policies

The presence of externalities is the main theoretical justification for deviating from policy neutrality.[2] Learning externalities from exports could justify export subsidies; knowledge spillovers from foreign companies could justify tax breaks for FDI; production externalities in “advanced” sectors could justify infant-industry protection or other measures to expand those industries.

The textbook model of IP is based on the idea that some sectors or industries exhibit Marshallian externalities, which are local externalities that increase with the size of the industry.[3] These externalities can arise through localized industry-level knowledge spillovers, input-output linkages together with transportation costs to ensure that the externalities remain local, and labor pooling. Marshallian externalities give rise to geographic agglomeration of industries (e.g., software in Silicon Valley), which have been emphasized in the literature on economic geography.[4]

The simplest model of IP entails a small-open economy with two sectors. Sector 1 has constant returns to scale (CRS) while Sector 2 has Marshallian externalities. The key result is that under some conditions there are multiple equilibria, with the equilibrium with complete specialization in Sector 2 being superior to the one with complete specialization in Sector 1. One could say that the economy has a “latent” comparative advantage in Sector 2 but that a coordination failure prevents it from exploiting this advantage. This concept has been formalized by a number of economists.[5]

Since the realization of Marshallian externalities is likely to take some time, it is customary to talk about countries having a “dynamic” comparative advantage [6] in sectors other than the ones in which they are currently specialized, and to think of industrial policy as the way to undertake the necessary transformation to capitalize on that dynamic advantage. This is the main theoretical justification for infant-industry protection, one of the best known justifications for industrial policy.

If a country does not have a “latent” comparative advantage in sectors likely to have Marshallian externalities, is there still a case to be made for industrial policy? Such policies could make sense if there are rents associated with the advanced sector, so that its international price is high relative to its cost; or if there are interindustry externalities, so that a large advanced sector increases the economy’s productivity across the board.

Protection is never the first-best policy. Even when protection could improve welfare, a production subsidy would be more efficient since it avoids the temporary consumption losses associated with protection. In addition, protection may not work if the market failure is due to sector-specific coordination problems, since tariff-induced growth does not necessarily help to solve coordination failures.[7] If protection is proposed instead of other policy instruments, then this is usually because a production subsidy is not practical for fiscal, political, or practical considerations. An important implication is that if fiscal considerations are the reason to use trade protection rather than production subsidies, then clearly tariffs would be the right policy and not quantitative restrictions.

But does industrial policy make sense in practice?

While many kinds of market failures could justify government intervention in theory, the critical questions remain: Does IP work in practice? How can we design IP to withstand government failure and achieve development goals? There are three general approaches that have been used to evaluate the effectiveness of IP.

The first approach focuses on particular industries that have received protection, such as the steel rail industry in the United States and semiconductors in Japan. The few studies of this nature suggest that the conditions necessary to generate positive net welfare gains from infant-industry protection are difficult to satisfy.[8] Typically, these studies find that protection may lead to higher growth but result in net welfare losses. More studies of this type—especially focused on developing countries—would be useful.

A second empirical strategy exploits the variation in productivity growth and different measures of support (including protection and production subsidies) across industries to see whether supported industries exhibit faster growth. Some studies show some support for infant-industry protection,[9] but most studies find the opposite: protected sectors grow more slowly. The removal of protection generates both intrafirm and intraindustry productivity gains (possibly through market share reallocations [10]).[11] A recent study shows that protected firms in China have exhibited lower productivity growth over the last decade, confirming that China is no different than other developing countries in this regard.[12]

Despite accumulating evidence suggesting a negative impact of protection on firm performance, there are significant problems with existing studies of infant-industry protection. Existing research does not try to identify interventions motivated for IP reasons, or were on the contrary driven by rent-seeking considerations. In fact, there is no evidence to suggest that intervention for IP reasons in trade even exists. If intervention were motivated by IP, one would expect the pattern of protection to be skewed toward activities where positive externalities or market failures are largest. Instead, existing evidence suggests that protection is more likely to be motivated by optimal tariff considerations, for revenue generation, or to protect special interests.[13] Tariff protection is also frequently granted to less successful firms or declining industries.[14]

A case in point is a recent study using a database on firms granted import licenses for raw materials and commodities in Indonesia to show that politically connected firms are more likely to be granted protection.[15] However, firms that export are significantly less likely to be granted support. This suggests that firms most likely to succeed on world markets in Indonesia were in fact penalized by restricting their access to import licenses.

The third approach to evaluating IP is the cross-country approach. These types of studies fall into two general types: those that evaluate the pattern of protection and reduced form approaches that examine the broad relationship between openness to trade and long-run growth. Perhaps most interesting are recent studies which emphasize the importance of the pattern of protection in understanding possible linkages between IP and economic growth.[16] Two studies find a positive correlation between import tariffs and economic growth across countries during the late nineteenth century, and hypothesize that protection was associated with growth because it allowed countries to accelerate the growth of what were then “emerging” sectors (industry) out of “declining sectors” (agriculture).[17] These emerging sectors were characterized by learning effects and the kinds of Marshallian externalities discussed earlier. These new explanations for the observed positive relationship between growth and protection at the turn of the twentieth century could also be used to explain how first Britain, and then the United States, were able to emerge as economic leaders in conjunction with tariffs that were very high in the eighteenth and nineteenth centuries.

What you protect also matters.[18] Countries which protect sectors that do not exploit their (latent) comparative advantage grow more slowly. If the pattern of protection is skewed toward increasing returns in sectors where there are important externalities, then IP would be much more likely to work than if protection is given to declining sectors or sectors without externalities. The pattern of protection and growth for a sample of developed countries during the period between 1875 and 1913 shows that while agricultural tariffs were negatively correlated with growth, industrial tariffs were positively correlated with growth.

Other recent studies have also emphasized that the pattern of protection matters.[19] Countries which protect skill-intensive sectors grow more rapidly than countries which protect unskilled- labor-intensive industries. When tariffs are disaggregated into consumption, capital goods, and intermediate goods tariffs for the 1970s through the current decade, tariff protection affects growth more negatively if tariffs are on capital or intermediate goods.

Most studies do not take into account the pattern of protection but simply estimate the reduced reform relationship between openness to trade and economic growth. This literature faces a number of econometric challenges.[20] In particular, measuring openness to trade, identifying the direction of causality between openness and growth, and identifying additional controls to include in cross-country estimation are ongoing concerns. These studies generally find that (1) using trade volumes as a measure of openness leads to findings of positive relationships between changes in openness and growth, and (2) using tariffs as a measure of openness for the post-World War II period is generally associated with an insignificant effect of average tariffs on growth.

Can the reduced form approach to evaluating the linkages between trade and growth cast light on the IP debate? The different results depending on how openness is measured imply that industrial policy is more likely to be successful if it is “pro-trade.” Yet from a practical standpoint, it is difficult to envision a successful set of policies that are both pro-trade and protectionist; at a minimum, this would require policies that fully offset any antitrade biases. Exchange rate undervaluation has been proposed as a policy that promotes the production of tradables, but such an approach is also likely to have “beggar-thy-neighbor” consequences.[21]

Three promising new areas of research deserve mention. Most of the work on trade and growth uses a measure of real GDP per capita or per capita growth as the dependent variable in cross-country growth regressions. Yet a number of studies have suggested that openness is important because it allows countries to invest more.[22] A second promising area of research is related to an emerging consensus on the need for openness to trade to be accompanied by key complementary policies. Recent research has emphasized the importance of complementarities between trade and other policies.[23]

A third exciting area for new research is to move beyond reduced form evidence on the linkages between openness and growth so that one can identify how openness to trade affects growth. This is particularly important from a policy perspective. If openness yields benefits because it allows firms to import new technology embodied in capital goods, the policy implications are quite different than if openness is beneficial because it forces firms to compete internationally or leads to market share reallocation toward more efficient firms. Identifying the mechanisms leading from openness to growth is precisely the focus of new theories of the firm.[24]

Foreign direct investment policies as industrial policy

Many countries encourage inward foreign direct investment through tax holidays, tariff exemptions, and subsidies for infrastructure because they expect that foreign firms will enable domestic enterprises to become technologically more advanced. In 1998, 103 countries offered tax concessions to foreign companies that set up production or other facilities within their borders.[25] China, for example, offered significantly lower corporate tax rates to foreign companies locating there until 2008, and continues to subsidize infrastructure investments for multinationals locating in foreign enterprise zones.

This is nothing other than industrial policy, although it is rarely identified as such. While economists are generally skeptical regarding the benefits of intervening in trade, they are much more likely to have interventionist priors when it comes to FDI. Is this pro-interventionist stance with respect to FDI justified?

There is significant research interest in FDI as a vehicle through which developing country firms learn about new technology. Most of the existing research tries to identify whether foreign firms convey productivity benefits to domestic enterprises, or helps them enter new export markets. On technology transfer, a consensus has emerged. Firms that receive FDI (joint ventures) or are acquired by multinationals generally exhibit higher productivity levels than comparable domestically owned firms. There is evidence of positive vertical spillovers from foreign buyers to domestic suppliers (backward linkages) and from foreign suppliers to domestic buyers (forward linkages) but that horizontal linkages (between foreign firms and domestic enterprises in the same sector) are small or negative. These stylized facts are surprisingly consistent across countries; research to date has evaluated a number of countries in Eastern Europe, Africa, and Asia.

Given these results, are fiscal incentives for foreign enterprises warranted? If the primary reason for giving these incentives is to encourage technology transfer, then the answer should probably be no: if foreign firms are the only ones that use the inputs that benefit from backward spillovers and there are no horizontal spillovers, then there is no need to subsidize FDI. Yet there is clearly a further need to understand the mechanism through which foreign firms generate vertical spillovers. Even if vertical spillovers do exist, some argue that “the magnitude of some of the incentives being used seems difficult to justify.” This research also points out that “investment incentives and tax breaks to multinational investors work against their local competitors.”[26]

Studies have also found that foreign firms help exporters break into new markets,[27] and pay workers in the host country higher wages. While the first research in this area found larger wage premia of more like 20 percent, these earlier estimates failed to adequately control for individual characteristics of workers, such as education and experience. More recent studies that use matched worker and employer datasets do continue to find a wage premium for workers employed by foreign owned firms, but the premium is much smaller. There is also evidence that foreign firms are more susceptible to pressure from labor groups, leading them to be exhibit greater compliance with minimum wages and labor standards.[28]

What are the implications for developing country policies?

While infant-industry protection is hard to endorse from past experience, it is also hard to defend a view that a uniform and low tariff is a disaster for development. There are instances where infant-industry protection was successful—particularly in the late nineteenth and early twentieth centuries—and could work today in developing countries. The theoretical justification for intervention requires at a minimum either industry-level rents or a latent comparative advantage, as well as large Marshallian externalities from production. While these necessary conditions are not easy to identify for policy makers ex ante, in principle such targeting could be successful. More worrisome is the fact that developing countries have generally not protected those sectors with latent comparative advantage and Marshallian externalities.

For infant-industry protection to improve welfare it must pass both the Mill and Bastable tests. The Mill test requires that the protected sector can eventually survive international competition without protection, whereas the Bastable test requires that the discounted future benefits compensate the present costs of protection. This means that the dynamic forces which increase industry productivity must operate quickly. In practice, most research assessing the success of IP has ignored these tests.

A number of other considerations are in order. Protection is typically not the first-best policy. In addition, the infant-industry framework typically assumes that the mere expansion of a sector will generate all sorts of positive effects that will increase industry-wide productivity. But this may not happen, and the economy may simply end up with a larger version of the inefficient sector it began with. It may be better to implement policies designed directly to elicit the investments that will increase productivity. Such investments may not occur without public intervention because of coordination failures.

The hundreds of studies on trade policies, trade shares, productivity, and growth show a strong correlation between increasing trade shares and country performance, and no significant correlation between tariffs on final goods and country outcomes. Putting aside the (serious) problems of reverse causality, the evidence can be interpreted as suggesting that trade and FDI policies are most successful when they are associated with increasing exposure to trade. One implication is that interventions that increase exposure to trade (such as export promotion) are likely to be more successful than other types of interventions (such as tariffs or domestic content requirements).

One can remain skeptical that protection or subsidies to FDI are needed. Nevertheless, new evidence suggests that IP through FDI promotion may be more successful than intervention in trade, in part because FDI promotion policies focus on new activities rather than on protecting (possibly unsuccessful) incumbents. If such measures are part of a broader effort to achieve technological upgrading then they may be helpful, whereas if they are implemented in isolation they are likely to fail.

The long-running discussion about “picking winners” can be sidestepped by focusing on efforts of “discovery”,[29] or by simply working with existing industries and clusters to deal directly with the coordination failures that limit their productivity and expansion. For example, instead of blanket subsidies for exports and FDI, one can try to attract multinationals to produce key inputs or to bring specific knowledge needed by clusters with the ability to absorb them. “Without host-country policies to develop local capabilities, MNC-led exports are likely to remain technologically stagnant, leaving developing countries unable to progress beyond the assembly of imported components.”[30]

There is an important role for “soft” industrial policy, whose goal is to develop a process whereby government, industry, and cluster-level private organizations can collaborate on interventions that can directly increase productivity.[31] The idea is to shift the attention from interventions that distort prices (i.e., “hard” IP) to interventions that deal directly with the coordination problems that keep productivity low in existing sectors. Thus, instead of tariffs, export subsidies, and tax breaks for foreign corporations, we think of programs and grants to, for example, help particular clusters by increasing the supply of skilled workers, encouraging technology adoption, and improving regulation and infrastructure. While “hard” IP is easier to implement than “soft” IP measures, tariffs and subsidies become entrenched and are more easily subject to manipulation by interest groups.

The specific policies that should be pursued as part of this type of IP depend, of course, on the particular coordination failures that affect a cluster. Given the variety of coordination failures that exist, there is a need for a wide set of instruments or policies. An exhaustive list is therefore impossible. Some examples are regulation to enforce higher quality standards in cases of imperfect information or externalities; public investment in specific infrastructure projects when there are strong investment complementarities (e.g., a regional airport geared to exploit tourism opportunities, or an irrigation project for modern agriculture); attraction of FDI to bring in foreign technologies; scholarships for studies abroad in areas deemed important for growth, and diversification of a cluster in cases where thin markets prevent individuals from making such investments; grants for innovative projects proposed by single firms or entrepreneurs, prizes to innovative firms, grants for research projects proposed by organized producers and performed by local research centers, and technical assistance to allow long-term collaborative strategies for education and research between business associations and universities.

It is clearly unreasonable to expect governments to be able to identify the coordination failures affecting different sectors or clusters. A more realistic approach is to invite sector and cluster organizations to come forward with well-justified proposals for government support. Perhaps the government should provide support to different sectors that want to start or improve their level of organization. This would be the first line of action in countries where the private sector organizations are weak or are designed for rent-seeking or confrontation rather than constructive work.

In comparison with the more traditional approach to IP, the soft IP approach has two the additional advantages. First, although this requires more research, the idea is that a soft IP reduces the scope for corruption and rent-seeking associated with hard IP such as protection or selective production subsidies. Second, soft IP is much more compatible with the multilateral and bilateral trade and investment agreements that many developing countries have implemented over the last decades. It is true that if a developing country wants to protect an industry for a period of time, it can always negotiate “space” for that policy when it joins the World Trade Organization (WTO). This is warranted under the WTO’s rules for special and differential treatment (SDT), which call for “preferential market access for developing countries, limits reciprocity in negotiating rounds to levels “consistent with development needs” and provides developing countries with greater freedom to use trade policies than would otherwise be permitted by GATT rules.”[32] But if the country has already joined the WTO then this is not possible. Moreover, export subsidies are supposed to be eliminated by all but the poorest countries by 2015 (agreement on subsidies and countervailing measures), local content requirements on multinationals are now WTO-illegal (agreement on trade-related investment measures, TRIMS), and patent laws are supposed to be set according to international standards (agreement on trade-related intellectual property, TRIPS). Such restrictions make it impossible for developing countries to follow some of the policies implemented by South Korea and Taiwan.[33] Of course, some policies associated with hard IP remain feasible: countries can provide fiscal incentives to particular sectors or to new activities. But clearly the policy space for hard IP has shrunk over the last decades, while that for soft IP remains basically unrestricted.

5. See recent the survey by Harrison and Rodriguez-Clare (2009). Lin (2009) proposes a related idea, when he suggests that government interventions should not go against a country’s comparative advantage.

11. This includes work by Pavcnik (2002), Tybout and Westbrook (1995) for Mexico, Harrison (1994) for Côte d’Ivoire, Nishimizu and Page (1982) for Yugoslavia, Kim (2000) for South Korea, Topalova (2004) for India, Muendler (2004) for Brazil, Beason and Weinstein (1996) for Japan, and others.

13. On tariff considerations see Broda, Limao and Weinstein (2006). On the use of IP protect special interests see Gawande, Krishna, and Olarreaga (2005); Goldberg and Maggi (1999): Mobarak and Purbasari (2006).